NBER WORKING PAPER SERIES TECHNOLOGY AND ECONOMIC PERFORMANCE IN THE AMERICAN ECONOMY. Robert J. Gordon

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1 NBER WORKING PAPER SERIES TECHNOLOGY AND ECONOMIC PERFORMANCE IN THE AMERICAN ECONOMY Robert J. Gordon Working Paper NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA February 2002 This research was supported by the National Science Foundation. I am grateful to Richard Nelson, Benn Steil, and David Victor for helpful comments and to Stuart Gurrea for preparing the figures. The views expressed herein are those of the author and not necessarily those of the National Bureau of Economic Research by Robert J. Gordon. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including notice, is given to the source.

2 Technology and Economic Performance in the American Economy Robert J. Gordon NBER Working Paper No February 2002 JEL No. O30, O40, O51 ABSTRACT This paper examines the sources of the U. S. macroeconomic miracle of and attempts to distinguish among permanent sources of American leadership in high-technology industries, as contrasted with the particular post-1995 episode of technological acceleration, and with other independent sources of the economic miracle unrelated to technology. The core of the American achievement was the maintenance of low inflation in the presence of a decline in the unemployment rate to the lowest level reached in three decades. The post-1995 technological acceleration, particularly in information technology (IT) and accompanying revival of productivity growth, directly contributed both to faster output growth and to holding down the inflation rate, but inflation was also held down by a substantial decline in real non-oil import prices, by low energy prices through early 1999, and by a temporary cessation in of inflation in real medical care prices. In turn low inflation allowed the Fed to maintain an easy monetary policy that fueled rapid growth in real demand, profits, and stock prices, which fed back into growth of consumption in excess of growth in income. The technological acceleration was made possible in part by permanent sources of American advantage over Europe and Japan, most notably the mixed system of government- and privately-funded research universities, the large role of U. S. government agencies providing research funding based on peer review, the strong tradition of patent and securities regulation, the leading worldwide position of U.S. business schools and U. S.-owned investment banking, accounting, and management-consulting firms, and the particular importance of the capital market for high-tech financing led by a uniquely dynamic venture capital industry. While these advantages help to explain why the IT boom happened in the United States, they did not prevent the U. S. from experiencing a dismal period of slow productivity growth between 1972 and 1995 nor from falling behind in numerous industries outside the IT sector. The productivity growth revival was fragile, both because a portion rested on unsustainably rapid output growth in , and because much of the rest was the result of a doubling in the growth rate of computer investment after 1995 that could not continue forever. The web could only be invented once, Y2K artificially compressed the computer replacement cycle, and some IT purchases were made by dot-coms that by early 2001 were bankrupt. As an invention, the web provided abundant consumer surplus but no recipe for most dot-coms to make a profit from providing free services. High-tech also included a boom in biotech and medical technology, which also provided consumer surplus without necessarily creating higher productivity, at least within the feasible scope of output measurement. Robert J. Gordon Department of Economics Northwestern University Evanston, IL and NBER (847)

3 Introduction The miracle of U. S. economic performance between 1995 and mid-2000 was a source of pride at home, of envy abroad, and of puzzlement among economists and policymakers. 1 The Federal Reserve presided over quarter after quarter of output growth so rapid as to break any speed limit previously believed to be feasible. As the unemployment rate inched ever lower, reaching 3.9 percent in several months between April and October, 2000, the Fed reacted with a degree of neglect so benign that late in the year 2000 short-term interest rates were barely higher than they had been five years earlier and long-term interest rates were considerably lower. 2 The miracle began to unravel in the U. S. stock market, when the tech-influenced NASDAQ stock market index fell by half between March and December, Soon the unraveling reached the real economy, with a steady decline in the growth rate of computer investment after the beginning of 2000 and a decline in the level of industrial production after September. As this paper went to press, it was not yet clear whether the evident slowdown in U. S. economic activity in would be of short or long duration, and to what extent the pillars of the miracle would crumble or just shed a bit of dust. Whatever the ultimate dimensions of the post-2000 economic slowdown and its aftermath, much of the achievement was sure to remain, including the fruits of the post-1995 productivity growth revival, the investment goods and consumer durables that were produced during the investment boom, and acknowledged U. S. leadership in the information 1. Lawrence Summers spoke for many economists and policymakers recently when he characterized this widespread puzzlement as "paradigm uncertainty." See Business Week, "The Economy: A Higher Safe Speed Limit," April 10, 2000, p The Treasury bill rate in September, 2000 at 6.00 percent was barely higher than the 5.64 percent registered in December, 1994, while the 30-year government bond rate over the same period fell from 7.87 percent to 5.83 percent.

4 Technology and Economic Performance, Page 2 technology (IT) industries that had sparked the boom. This paper is primarily concerned with the conjunction of events that help us to understand the miracle, including those transitory components of the economic environment which ultimately disappeared and help us understand why the period of rapid growth eventually came to an end. The essence of the miracle was the conjunction of low unemployment and low inflation. Fed policy avoided any sharp upward spike in short-term interest rates such as had happened during the previous expansion in because of the perception that accelerating inflation was not a problem, despite a much lower unemployment rate than the minimum achieved in the earlier expansion. Policy reactions were less aggressive in the late 1990s than in the late 1980s, because the economy appeared to have experienced a sharp change in behavior along at least two dimensions. Unemployment could be allowed to decline because inflation remained low. The second change of behavior was in the growth of productivity. After resigned acceptance of the so-called "productivity slowdown," more than two decades following 1973 when output per hour grew at barely one percent per annum (well under half of the rate experienced before 1973), analysts were astonished to observe productivity growth at a rate of nearly three percent as the average annual rate for and an unbelievable 5.3 percent in the four quarters ending in mid Falling unemployment, low inflation, and accelerating productivity growth brought many other good things in their wake. In February, 2000, the American economy set a record for the longest business expansion since records began in Profits surged and, at least 3. Part of this change in perception was an illusion based on a change in the measuring rod. The annual growth rate of output per hour for was 1.1 percent per year based on data available prior to 1999 but jumped to 1.5 percent per year as a result of data revisions announced in late 1999.

5 Technology and Economic Performance, Page 3 until early in the year 2000, stock market prices grew even faster than profits, showering households with unheard-of increases in wealth that in turned fueled a boom in consumption and an evaporation of household saving (at least as conventionally measured, excluding capital gains). The Federal government participated in the good times, enjoying a 64 percent increase in personal income tax revenues between 1994 and 1999, fueled by strong income growth and the capital gains resulting from a tripling of stock market prices over the same interval. 4 And the gains from the boom were not limited to the top 5 or 10 percent of the income distribution. For the first time since the early 1970s, gains in real income were enjoyed by households in the bottom half of the income distribution, and in April, 2000, the unemployment rates for blacks and Hispanics reached the lowest levels ever recorded. 5 Perhaps the greatest contrast of all was between the glowing optimism in early 2000 that all was right with the American economy, especially in contrast to most of the other developed nations, whereas a decade earlier nothing seemed to be going right. In The S&P 500 stock market index increased from an average of 455 in December, 1994, to 1505 in the week ending April 1, 2000, but fell to 1320 at year-end 2000 and 1148 at year-end Data on real family incomes show a pattern of equal growth rates by income quintile for but sharp divergence between decreases at the bottom and increases at the top during See Michel et. al. (1999), Figure 1E, p. 52.

6 Technology and Economic Performance, Page 4 Japan had been king of the mountain, and the United States then appeared to be clearly inferior to Japan along almost every dimension, including inflation, unemployment, productivity growth, technical dynamism, and income inequality. The emerging economic slowdown in late 2000 and early 2001 suggested that the American switch from an inferiority to a superiority complex had been too abrupt, and that the miracle of the late 1990s had perhaps been less permanent and complete than economic pundits had proclaimed only a year earlier. If there was a consensus about anything as the boom years of the miracle were followed by a slowdown and perhaps a subsequent recession, it was that the core of the miracle was an acceleration in technological progress centered around the "New Economy" of computers, IT more generally, and the internet, and that the clearest manifestation of the miracle in the economic data the post-1995 productivity growth revival could be traced directly to the IT revolution. One way of describing the changing relationship between technology and economic performance is through Robert M. Solow's famous 1987 saying that "we can see the computer age everywhere but in the productivity statistics." For a decade economists took "Solow's paradox" as a truism, noting the continuing co-existence of explosive growth in computer use and dismal growth in labor productivity, and they differed only in their explanations. 6 But by a consensus emerged that the technological revolution represented by the New Economy was responsible directly or indirectly not just for the productivity growth acceleration, but also the other manifestations of the miracle, 6. The explanations included "the computers are not everywhere," or "there must be something wrong with the productivity statistics," or "there must be something wrong with the computers." The best compendium and assessments of these and other alternative explanations is provided by Triplett (1999).

7 Technology and Economic Performance, Page 5 including the stock market and wealth boom and spreading of benefits to the lower half of the income distribution. In short, Solow's paradox is now obsolete and its inventor has admitted as much. 7 This paper explores the interrelations between the ebb and flow of U. S. economic performance and the role of technology. We quantify the role of technology in general and IT in particular in achieving the U. S. productivity acceleration of the late 1990s and provide an analysis that suggests that some of the acceleration may be temporary and may not persist. In determining the role of alternative sources of the technological acceleration and American domination of IT manufacturing and software production, we shall explore the role of mechanisms and incentives in the private sector, foreign competition, and government policy. The role in the U. S. success of its heterogeneous system of public and private universities, peer-reviewed government research grants, and strong tradition of patent and securities regulation are also emphasized. The paper concludes with observations on the role of immigration as a source of recent American success and an area where policy has an important role to play. Throughout the analysis, the American success story is qualified not just by the emergence of an economic downturn in , but also by the remaining less favorable elements of American exceptionalism when viewed from abroad, especially rising economic inequality that limited the spread of the "miracle" across the income distribution. Dimensions of Macroeconomic Performance 7. Solow is quoted as such in Uchitelle (2000).

8 Technology and Economic Performance, Page 6 We begin by examining several indicators of economic performance and discuss several hypotheses that have been suggested to explain the multi-dimensional improvement of performance in the late 1990s. Inflation and Unemployment Figure 1 plots the unemployment rate on the same scale as the inflation rate for the Personal Consumption deflator. 8 The unemployment rate in fell to four percent, the lowest rate since the period during which inflation accelerated steadily. Yet in 1998 and early 1999, prior to the upsurge in oil prices, inflation not only failed to accelerate but rather decelerated. Taking a general view of the unemployment-inflation relationship, it appears superficially that the only support for a negative Phillips-curve unemployment-inflation tradeoff is based on the 1960s Vietnam-era experience, with a bit of further support from the economic expansion of In other periods, especially during and , the unemployment and inflation rates appear to be positively correlated, with the unemployment rate behaving as a lagging indicator, moving a year or two later than inflation. While this appearance of a positive tradeoff led some economists, notably Robert E. Lucas, Jr. and Thomas Sargent back in the 1970s to declare the Phillips curve to be "lying in wreckage," at the same time a more general model of inflation determination was developed that combined an influence of demand (i.e., a negative short-run relation between inflation and unemployment), supply (in the form of "supply shocks" like changing real oil prices), 8. The deflator for Personal Consumption Expenditures, part of the National Income and Product Accounts, is preferable to the Consumer Price Index because it has been revised retrospectively to use a consistent set of measurement methods, whereas the CPI is never revised.

9 Technology and Economic Performance, Page 7 slow inertial adjustment, and long-run independence of inflation and the unemployment rate. 9 During the 1980s and the first half of the 1990s this more general model was adopted as the mainstream approach to inflation determination by textbook authors and policymakers alike, but in the late 1990s it was challenged again by the simultaneous decline in unemployment and deceleration of inflation evident in Figure 1. At the end of the decade no consensus had yet emerged to explain the positive correlation of inflation and unemployment in the late 1990s. I have attempted to use a common framework to explain why the performance of the 1970s was so bad and of the 1990s was so good, pointing to the role of adverse supply shocks in the earlier episode and beneficial supply shocks more recently. In my interpretation (1998) inflation in was held down by two "old" supply shocks, falling real prices of imports and energy, and by two "new" supply shocks, the accelerating decline in computer prices (see Figure 9 below) and a sharp decline in the prices of medical care services made possible by the managed care revolution. In retrospect my analysis, while still valid regarding the role of the supply shocks, did not place sufficient emphasis on the productivity growth revival as an independent source of low inflation. Between 1995 and late-2000 wage growth accelerated substantially from 2.1 to above 6 percent at an annual rate, thus appearing to validate the Phillips curve hypothesis of a negative tradeoff between unemployment and wage growth. 10 However, soaring productivity growth during the same period prevented faster wage growth from translating into growth in unit labor costs (defined as wage growth minus productivity growth). If 9. The more general approach was developed in Gordon (1977, 1982). The evolution of this approach is described in Gordon (1997). 10. These figures refer to the growth in nonfarm private compensation per hour.

10 Technology and Economic Performance, Page 8 productivity growth were to decelerate, then it added one more element to the list of transitory elements that had held down inflation in the late 1990s. Any of the items on the list falling relative import and energy prices, a faster rate of decline in computer prices, moderate medical care inflation, and the productivity growth revival itself could turn around and put upward rather than downward pressure on the inflation rate. This had already begun to happen as a result of higher energy prices, as the growth rate of the price index for personal consumption expenditures had already more than doubled from 1.1 percent in 1998 to 2.4 percent in Figure 2 compares (with annual rather than quarterly data) the actual unemployment rate with the natural unemployment rate (or NAIRU). The concept of the natural unemployment rate used here attempts to measure the unemployment rate consistent with a constant rate of inflation in the absence of the "old" supply shocks, changes in the relative prices of imports and energy. 11 The acceleration of inflation during and the deceleration of inflation during are explained by movements of the actual unemployment rate below and then above the natural rate. It is the dip of the actual unemployment rate below the natural unemployment rate in which raises questions about the behavior of inflation. 12 Perhaps the natural rate has declined more than is depicted 11. Allowance is also made for the role of the imposition and removal of the Nixon-era price controls during In Figure 1 the decline of inflation in and its resurgence in can be explained entirely by the "old" supply shocks, the behavior of the real prices of imports and energy.

11 Technology and Economic Performance, Page 9 here. 13,14 Monetary Policy, the "Twin Deficits," Saving, and Investment The response of the Fed's monetary policy is summarized in Figure 3, which displays annual values of the Federal funds rate, which is controlled directly by the Fed, and the corporate bond rate. The Federal funds rate barely changed on an annual basis in the five years and during that period was much lower than reached in previous tight money episodes in 1969, 1974, 1981, and 1989, each of which can be interpreted as the Fed's response to an inflation acceleration that did not occur in Throughout the 1990s the corporate bond rate declined, reflecting both the behavior of short-term interest rates and also the perception that corporate bonds had become less risky as memories of the most recent recession receded into the past. The level of the corporate bond rate in 1999 was lower than in any year since 1969, helping to explain the longevity of the economic expansion and the ongoing boom in investment. Until the late 1990s the U. S. economy appeared to be plagued by the "twin deficits," 13. Subsequent to my research on the NAIRU (Gordon, 1998), Eller (2000) has updated my research and made numerous improvements in my specification. However, Eller is unable to find any technique which yields a NAIRU below 5.0 percent in late In addition to the role of computer prices and medical care prices in holding down inflation relative to that which would be predicted by the unemployment gap in Figure 2, several other changes in labor markets are considered by Katz and Krueger (1999). These include a declining share of youth in the working-age population, the imprisonment of some young adult males who would otherwise be unemployed, and the increased role in matching jobs and the unemployed played by temporary help agencies. I would add to this list the benefit of legal and illegal immigration in providing an additional supply of workers needed by tight labor markets (I return to this theme at the end of the paper).

12 Technology and Economic Performance, Page 10 namely the government budget deficit and current account deficit. 15 In the casual discussion of causation that became typical during the 1980s and early 1990s, U. S. domestic saving was barely sufficient to finance domestic investment, requiring that any government deficit be financed by foreign borrowing. When both the government budget surplus and current account surplus are plotted as a share of GDP, as in Figure 4, we see that a tight relation between the "twin surplusses" or "twin deficits" is more the exception than the rule and occurred most notably during the intervals and In the 1990s the two deficits have moved in opposite directions to an unprecedented degree the arithmetic difference between the government surplus and current account surplus changed from -4.2 percent of GDP in 1992 to +7.3 percent of GDP in 2000, a swing of 11.5 percent of GDP, or more than $1 trillion. This dramatic swing is easy to explain qualitatively if not quantitatively. A booming economy boosts the government budget surplus as revenue rises more rapidly than expenditures but also turns the current account toward deficit as imports grow more rapidly than exports. The magnitude of the current account deterioration seems roughly consistent with the excess of economic growth in the U. S. compared to its trading partners (the ability of which to purchase U. S. exports during was impaired by the financial crises in 15. All references to the government budget deficit in this paper refer to the combined current surplus or deficit of all levels of government federal, state, and local. See Economic Report of the President, January 2001, Table B-82, third column, p The identity governing the relationship in Figure 4 is that the government budget surplus (T-G) equals the current account surplus (X-M) plus the difference between domestic private investment and domestic private saving (I-S). During most of the period between 1974 and 1995, the government budget surplus was a larger negative number than the current account surplus, implying that investment was substantially less than saving. After 1996 this relationship reversed sharply.

13 Technology and Economic Performance, Page 11 Asia, Brazil, and Russia, and continuing stagnation in Japan). But the magnitude of the government budget improvement appears to defie explanation, as each successive forecast by the Congressional Budget Office became waste paper almost as fast as it was published. Landmarks in the budget turnaround were the tax reform legislation of 1993 and 1996 and the huge surge of taxable capital gains generated by the stock market boom. During the long period during which the government ran a budget deficit, a consensus emerged that the main harm done by the deficit was the erosion of "national saving," the sum of private saving and the government surplus. 17 Since private investment could exceed national saving only through foreign borrowing, a low rate of national saving inevitably implied a squeeze on domestic investment, a reliance on foreign borrowing with its consequent future interest costs, or both. The only solution was to achieve some combination of a marked increase in the private saving rate or a turnaround in the government budget from deficit to surplus. Indeed, this pessimistic interpretation was validated in the numbers for a year as recent as 1993, when the net national saving rate reached a postwar low of 3.4 percent of GDP, down from a peak of 12.1 percent in 1965, and net domestic private investment was only 4.5 percent, down from 11.3 percent in 1965 (see Figure 5). Those who had predicted that an ending of government deficits would stimulate private investment were vindicated, as the increase in the investment ratio of 4.2 percentage points absorbed much of the increase in the government budget surplus over the 17. Using the notation in the previous footnote, national saving equals total investment, domestic and foreign: S + T-G = I + X-M.

14 Technology and Economic Performance, Page 12 same period of 7.1 points. The increase in national saving made possible by the budget turnaround was, however, almost entirely offset by a decline in the private saving ratio of 6.3 percent, requiring added borrowing from abroad (an increase in the current account deficit of 3.4 percent) to finance the extra investment. 18 Since these ratios are linked by definitional relationships, there is no sense in which these movements can be linked by attributions of cause and effect. It would be just as accurate to say that everything that changed after 1993 was an indirect effect of the New Economy and accompanying technological acceleration which (a) boosted the government budget through income growth and capital gains, (b) created new incentives for private investment, (c) raised imports more than exports by boosting domestic income growth compared to foreign income growth, and (d) caused private saving to erode as stock market gains boosted the growth of domestic consumption beyond that of disposable income. The final element in this chain of causation, the link between the stock market boom and the collapse of household saving, is illustrated separately in Figure 6. If we relate the S&P 500 stock market index to nominal GDP, this ratio more than doubled in the four short years between 1995 and 1999, after declining by two-thirds between 1965 and The negative correlation between the stock market ratio and the household saving rate is evident in the data and is just what would be expected as a result of the "wealth effect" embedded in Modigliani's original 1953 life-cycle hypothesis of consumption behavior. Putting Figures 5 and 6 together, we see that in the late 1990s rapid economic growth was fueled both by an 18. The data compare 1993 with 2000:Q3 and are taken from the Economic Report of the President, January 2001, Table B-32, pp Private saving is taken as the printed number plus the statistical discrepancy, and the government surplus is derived as a residual (T-G = I-S+NX).

15 Technology and Economic Performance, Page 13 investment boom financed by foreign borrowing and by a consumption binge financed by capital gains. Both of the latter were related, because the current account deficit was financed by willing foreigners eager to benefit from profits and capital gains in the buoyant American economy; a reversal of the stock market could cause all of this to unravel, including an end to the excess of growth in consumption relative to growth in disposal income, as well as a withdrawal of foreign funds that would push down the U. S. dollar. While some worried that private indebtedness would also emerge as a problem if the stock market declined, ratios of consumer and mortgage debt had actually increased little in relation to income and had fallen greatly in relation to wealth. 19 Productivity, Real Wages, and Income per Capita Thus far we have examined several manifestations of the American economic miracle of the late 1990s without focussing explicitly on the single most important factor which made all of this possible, namely the sharp acceleration in productivity growth that started at the end of 1995 and that was presumably caused entirely or in large part by the technological acceleration that we have labelled the "New Economy." Figure 7 divides the postwar into three periods using the standard quarterly data published by the Bureau of Labor Statistics (BLS), the "golden age" of rapid productivity growth between 1950:2 and 1972:2, the dismal slowdown period extending from 1972:2 to 1995:4, and the revival period since 1995:4. 20 The 19. The ratio of outstanding consumer credit to GDP rose from 1987 to 2000:Q3 only from 14.2 to 14.8 percent, and total outstanding mortgage debt only from 63.2 to 67.8 percent. See Economic Report of the President, January 2001, Tables B-77 and B-75, respectively. 20. These precise quarters are chosen because they have roughly the same unemployment rate of about 5.5 percent. The unemployment rate in the final quarter, 2000:1, was 4.1 percent, and we discuss below the possibility that some of the post-1995 productivity acceleration may have been a temporary cyclical phenomenon.

16 Technology and Economic Performance, Page 14 top frame shows that for the nonfarm private economy, the revival period registered a productivity growth rate that actually exceeded the golden age by a slight margin, while the middle frame shows that for manufacturing there never was a slowdown, and that the revival period exhibits productivity growth well over double the two previous periods. 21 As a result of the buoyancy of manufacturing, productivity growth outside of manufacturing in the revival period fell well short of the golden age although also exhibited a recovery from the slowdown period. Subsequently we will examine the contrast between a technological acceleration inside manufacturing, primarily in the making of computers, with the absence of any parallel acceleration in technological change outside of manufacturing. Perhaps no measure of well-being in the U. S. economy has experienced more of a revival than the growth in real wages, for this was the measure of performance for which progress was most dismal during the period. Table 1 compares the growth of nonfarm private output per hour with three measures of real wages, the first two of which deflate hourly compensation by alternative price indexes. Shown in line 2a is real compensation deflated by the deflator for the nonfarm private sector; this measure would grow at the same rate as productivity if the share of compensation in nonfarm private output were constant, which is roughly true in the long run. Line 2b records a slower growth rate of the real consumption wage, slower because during the postwar period the price index of consumption goods and services has increased faster than the price index for nonfarm private output, a difference due primarily to the falling prices of many types of machinery and 21. The reference above to pessimism based on productivity growth of "barely one percent" during the period refers to data that were revised upward in October, The average annual growth rate of nonfarm private output per hour during the period 1972:2-1995:4 is 1.42 percent in the newly revised data.

17 Technology and Economic Performance, Page 15 equipment, especially computers, relative to the prices of consumer services. The most pessimistic measure of all, shown on line 3 of Table 1, is also the most inaccurate, because it counts only part of compensation and uses a deflator (the CPI) which is biassed upward to a substantially greater extent than the PCE deflator used on line 2b. The pessimistic measure on line 3 implies that the real wage in 2000:Q3 was only 17.7 percent above that in 1959 (an annual growth rate of only 0.4 percent), whereas the measure on line 2b implies that over the same period the real wage more than doubled (an annual growth rate of 1.78 percent per year). Both measures imply a sharp acceleration of almost two percentage points when the last five years are compared with the previous eight years. A more comprehensive measure of well-being, per-capita real income, allows us to illustrate the progress that the U. S. economy has made in the last few years relative to the two other largest industrialized nations, Germany and Japan. Using measures that have been adjusted for the differing purchasing power of other currencies, U. S. per capita income was 25 percent higher than Germany in 1999, compared to margins of 21 percent in 1995, 16 percent in 1990, and 15 percent in Japan's rapid economic growth continued to 1990 and then stalled, and so it is not surprising that the U. S. margin over Japan widened from 22 percent in 1990 to 31 percent in However, those who would interpret these comparisons as evidence of U. S. technological success, or even more broadly as evidence that the U. S. has the "best" economic system, are reminded that growth rates of per capita income between these countries are not comparable. Only the U. S. measures the prices of computers with a hedonic price deflator, and this difference in measurement methodology alone over the interval adds about half a percent per year to per-capita U. S. real

18 Technology and Economic Performance, Page 16 income growth and, as stated above, subtracts about the same amount from U. S. inflation. 22 But this lack of comparability should not be overstated. Some comparisons of U. S. economic performance with leading foreign nations, e.g., those showing that the U. S. unemployment rate has declined faster and stock market valuations have increased faster, are unaffected by which technique is used to deflate computer expenditures. Interpreting the Dismal Slowdown Years, Before turning to a more detailed review of the role of IT in creating the post-1995 U. S. productivity growth revival, we should ask how the U. S. could have experienced such a long period of slow productivity growth between 1972 and 1995, particularly in light of the many structural advantages of the U. S. economy that became apparent after However, decades of fruitless research on the sources of the post-1972 slowdown suggest that this is the wrong question. First, the question is wrong because the U. S. slowdown was not unique, but rather with differences in magnitude and timing was shared by the rest of the industrialized world. Second, in a more important sense the question should be flipped on its head to ask not why productivity growth was so slow after 1972, but rather why productivity growth was so fast for so long before Every major industrialized country experienced a sharp slowdown in productivity growth after 1973, and the extent of the slowdown in most countries was greater than in the United States. During growth in productivity (ALP) in the 15 countries of the 22. In addition the U. S. national accounts were revised in 1999 back to 1959 to include investment in software which is partly deflated with a hedonic price index.

19 Technology and Economic Performance, Page 17 European Union was double and in Japan quadruple that in the U. S. In the 1970s and 1980s productivity growth slowed down everywhere, but later than in the U. S., and by the first half of the 1990s productivity growth in Europe and Japan had converged to that of the U. S. Thus the productivity slowdown was universal in the developed world rather than being unique to the U. S. The timing of the previous "golden age" of rapid productivity growth had also differed. Following a universal experience of slow productivity growth in the nineteenth century, the U. S. "golden age" began first, around 1915 and extended until 1972, whereas the golden age in Europe and Japan did not begin in earnest until the postwar reconstruction of the 1950s. Stated another way, the percentage degree of superiority of U. S. per-person GDP and of U. S. productivity began to accelerate around the turn of the century, reached its peak in 1945, and then steadily fell until the early 1990s, when the degree of superiority began to increase again (as discussed above in the context of Figure 8). The post-1972 slowdown in the U. S., Japan, and Europe can be traced back to the sources of the "golden age" which began around the time of World War I in the United States (Gordon, 2000a). A set of "great inventions" of unprecedented scope and importance, including electricity and the internal combustion engine, had been developed during the Second Industrial Revolution of and began the process of diffusion through the structure of the economy and society soon after the turn of the century (Gordon, 2000c). The productivity acceleration of the "golden age" occurred as the electric motor revolutionized manufacturing, as the internal combustion engine revolutionized ground transport and allowed the invention of air transport, and as other innovations in chemicals,

20 Technology and Economic Performance, Page 18 petroleum, entertainment, communication, and public health transformed the standard of living in the United States between 1900 and the 1950s. In addition to the original advantages of the United States, particularly economies of scale and a wealth of natural resources (Wright, 1990), the dislocation of the two world wars and the turbulent interwar period delayed the diffusion of many of these innovations in Europe and Japan until after 1945, but then the rich plate of unexploited technology led to a period of rapid catch-up, if not convergence, to the U. S. frontier. This interpretation explains the post-1972 productivity slowdown as resulting from the the inevitable depletion of the fruits of the previous great inventions. The faster productivity growth in Europe and Japan during , and the greater magnitude of their slowdowns, and the delayed timing of the slowdown into the 1980s and 1990s, is explained by the late start of Europe and Japan in exploiting the late 19th century "great inventions." Of course this story is too simple to account for the differing fortunes of individual industries; as Europe and Japan recovered and caught up, they did so more in some industries and others, so that by the late 1970s and early 1980s the U. S. automobile and machine tool industries seemed more obviously in the "basket case" category than pharmaceuticals or software. The Role of Information Technology in U. S. Economic Success How important has the New Economy and IT revolution been in creating the U. S. productivity revival which appears directly or indirectly to be responsible for most other dimensions of the late-1990s U. S. economic miracle? Fortunately we do not need to explore this question from scratch, since recent academic research has produced a relatively clear answer which is summarized and interpreted in this section. The basic answer is that the

21 Technology and Economic Performance, Page 19 acceleration in technical change in computers, peripherals, and semiconductors explains most of the acceleration in overall productivity growth since 1995, but virtually all the progress has been concentrated in the durable manufacturing sector, with surprisingly little spillover to the rest of the economy. To provide a more precise analysis we must begin by distinguishing between the growth in output per hour, sometimes called average labor productivity (ALP), from the growth of multi-factor productivity (MFP). The former compares output growth with that of a single input, labor hours, while the latter compares output with a weighted average of several inputs, including labor, capital, and sometimes others, including materials, energy, and/or imports. ALP always grows faster than MFP, and the difference between them is the contribution of "capital deepening," the fact that any growing economy achieves a growth rate of its capital input that is faster than its labor input, thus equipping each unit of labor with an ever-growing quantity of capital. 23 In all official BLS measures of MFP and in all recent academic research, both labor hours and capital input are adjusted for changes in composition. For labor the composition adjustment takes the form of taking into account the different earnings of different groups classified by age, sex, and educational attainment, and for capital it takes the form of taking into account the different service prices of long-lived structures and different types of shorterlived producers' equipment. Composition-adjusted growth in labor input is faster than in standard measures of labor input, since educational attainment has been increasing, whereas 23. Technically, the growth rate of ALP is equal to the growth rate of MFP plus the growth rate of the capital/labor ratio times the elasticity of output with respect to changes in capital input. Virtually all research on the sources of growth uses the share of capital income in total national income as a proxy for the unobservable elasticity of output to changes in capital input.

22 Technology and Economic Performance, Page 20 composition-adjusted growth in capital input is faster than the real stock of capital, since there has been a continuous shift from long-lived structures to shorter-lived equipment, and within equipment to shorter-lived types of equipment, especially computers. 24 The "Direct" and "Spillover" Effects of the New Economy How have computers and the New Economy influenced the recent productivity growth revival? Imagine a spontaneous acceleration in the rate of technological change in the computer sector, which induces a more rapid rate of decline in computer prices and an investment boom as firms respond to cheaper computer prices by buying more computers. 25 In response, since computers are part of output, this acceleration of technical change in computer production raises the growth rate of MFP in the total economy, boosting the growth rate of ALP one-for-one. Second, the ensuing investment boom raises the "capital deepening" effect by increasing the growth rate of capital input relative to labor input and thus increasing ALP growth relative to MFP growth. In discussing the New Economy, it is important to separate the computer-producing sector from the computer-using sector. No one denies that there has been a marked acceleration of output and productivity growth in the production of computer hardware, 24. A short-lived piece of equipment like a computer must have a higher marginal product per dollar of investment to pay for its high rate of depreciation, relative to a long-lived hotel or office building. Compositionadjusted measures of capital input reflect differences in the marginal products of different types of capital and thus place a higher weight on fast-growing components like computers and a lower weight on slow-growing components like structures. 25. As stated above, in the U. S. national accounts computer prices are measured by the hedonic regression technique, in which the prices of a variety of models of computers are explained by the quantity of computer characteristics and by the passage of time. Thus the phrase in the text "decline in computer prices" is shorthand for "a decline in the prices of computer attributes like speed, memory, disk drive access speed and capacity, presence of a CD-ROM, etc."

23 Technology and Economic Performance, Page 21 including peripherals. 26 The real issue has been the response of productivity to massive computer investment by the 96 percent of the economy engaged in using computers rather than producing them. 27 If the only effect of the technological breakthrough in computer production on the non-computer economy is an investment boom that accelerates the growth rate of capital input, then non-computer ALP growth would rise by the capital-deepening effect, but there would be no increase in non-computer MFP growth. Let us call this the "direct" effect of the New Economy on the non-computer sector. Sometimes advocates of the revolutionary nature of the New Economy imply that computer investment has a higher rate of return than other types of investment and creates "spillover" effects on business practices and productivity in the non-computer economy; evidence of this "spillover" effect would be an acceleration in MFP growth in the non-computer economy occurring at the same time as the technological acceleration in computer production. The Role of IT in the Productivity Growth Revival What is the counterpart of the New Economy in the official output data? The remarkable event which occurred at the end of 1995 was an acceleration of the rate of price change in computer hardware (including peripherals) from an average rate of 26. In this paper we emphasize computer hardware, rather than the universe of computer hardware, software, and telecommunications equipment, because the BEA deflators for software and telecommunications equipment are problematic, exhibiting implausibly low rates of price decline, as argued by Jorgenson and Stiroh (2000). 27. In 1999 nominal final sales of computers and peripherals plus fixed investment in software represented 3.5 percent of nominal GDP in the nonfarm nonhousing private business economy. Thus the "noncomputer part of the economy" represents 96.5 percent of nonfarm nonhousing private business output. Final sales of computer hardware is an unpublished series obtained from Christian Ehemann of the BEA; the other series in this calculation appear in the Economic Report of the President, February 2000, Tables B-10 and B-16.

24 Technology and Economic Performance, Page percent during to an average rate of -29 percent during Computers did not become more important as a share of dollar spending in the economy, which stagnated at around 1.3 percent of the nonfarm private business economy. The counterpart of the post-1995 acceleration in the rate of price decline was an acceleration in the rate of technological progress; apparently the time cycle of Moore's Law shortened from 18 months to 12 months at about the same time. 29 We now combine two different academic studies to assess the role of IT in contributing to the economywide acceleration in ALP and MFP growth since First, we use the recent results of Oliner and Sichel (2000, 2001) to compute the contribution of computers and semiconductors both to capital deepening and to the MFP acceleration in the overall economy. Second, we summarize my recent study (Gordon, 2000b) that adds two elements to the work of Oliner and Sichel. First, it uses official BLS data to "strip" the overall economy of the contribution of the ALP and MFP acceleration that is located within durable manufacturing, so that we can assess the extent of any spillover of IT in the 88 percent of the economy located outside of durables. Second, it updates my previous work on the cyclical behavior of productivity, which shows that there is a regular relationship between growth in 28. The numbers in the text refer to the annual rate of change of the BEA implicit deflator for investment in computers and peripherals between 1995:4 and 1998:4. One way of dramatizing the rate of price decline is to translate it into the ratio of performance to price when 1999:Q4 is compared with 1993:Q4. The BEA's implicit deflator for computer final sales implies an improvement over that six-year period by a factor of 5.2. Improvements in performance-price ratios for individual computer components are substantially larger, by a factor of 16.2 for computer processors, 75.5 for RAM, and for hard disk capacity. See "Computers, then and now," Consumer Reports, May, 2000, p. 10, where the published reported comparisons in 1999 dollars have been converted to nominal dollars using the Consumer Price Index. 29. Moore's law states that the number of transistors on a single computer chip doubles every eighteen months. The reduction in time from eighteen to twelve months is based on a conversation between Gordon Moore and Dale W. Jorgenson, related to the author by the latter.

25 Technology and Economic Performance, Page 23 hours relative to the trend in hours, and growth in output relative to the trend in output. We can use this statistical relationship based on data going back to the 1950s to estimate the trend of output and productivity growth during , given the trend in hours, and thus extract the remaining cyclical component, i.e., the difference between actual productivity growth and trend productivity growth. 30 The results displayed in Table 2 allow us to assess the direct and spillover effects of computers on output per hour and MFP growth during the period between 1995:Q4 and 2000:Q4. The first column refers to the aggregate economy, i.e., the NFPB sector including computers. Of the actual 2.86 percent annual growth of output per hour, 0.40 is attributed to a cyclical effect and the remaining 2.46 percent to trend growth, and the latter is 1.04 points faster than the trend. How can this acceleration be explained? A small part on lines 6 and 7 is attributed to changes in price measurement methods and to a slight acceleration in the growth of labor quality. 31 All of the remaining 0.89 points can be directly attributed to computers. The capital-deepening effect of faster growth in computer capital relative to labor in the aggregate economy accounts of 0.60 percentage points of the acceleration (line 9a) and a 0.30-point acceleration of MFP growth in computer and computer-related semiconductor manufacturing account (line 10) sum to an explanation of 0.90 points, compared to the The equations estimated are those developed in Gordon (1993). 31. The price measurement effect consists of two components. While most changes in price measurement methods in the CPI have been backcast in the national accounts to 1978, one remaining change the shift in medical care deflation from the CPI to the slower-growing PPI creates a measurement discontinuity of 0.09 percent. The fact that other measurement changes were carried back to 1978 rather than 1972 creates a further discontinuity of 0.05 when the full period is compared to The acceleration in labor quality growth reflects the fact that labor quality growth during was held down by a compositional shift toward female and teenage workers during the first half of that period.